Whose Health and Pension Risks?
by Warren Coats

The Social Security Trust Fund is actuarially bankrupt. United Airlines and a number of other American corporations (e.g., Enron) have defaulted on their employee pension plans as part of their own bankruptcy (or Chapter 11 reorganization). IBM and Verizon recently joined a growing number of firms in freezing traditional pension plans for existing workers, after having already dropped them for new hires. What is going on and is it good or bad?

The problems of the Social Security Fund are very different from those of United’s or IBM’s pensions. Social Security is financed on a pay as you go basis, so it is not a savings plan at all. The contributions of current workers are used to finance the pensions of those already retired. The system will be clobbered by the changing age composition of our population as retiring WWII baby boomers swell the ranks of the retired in the near future and the ratio of working Americans to pensioners drops dramatically.

The issues raised by the private, “defined benefit” pension plans that have been widely offered by American corporations since World War II are very different. These are genuine savings plans. Money is set aside (saved) to finance a future benefit. When a defined benefit pension is established for an individual employee, his or her contribution and that of the employer match what is estimated to be needed to fully fund the subsequent pension payments. However, as the years pass by the initial (actuarial) assumptions may turn out to be wrong. If the amount of the pension benefit is fixed, the error in the initial assumptions will result in the monthly contribution (the amount saved to finance the pension) being too little or too much for the benefit promised.

The two most critical assumptions made when establishing the monthly saving needed to finance a future pension are the return to the funds from investing what is saved (the interest rate), and the length of time the employee will draw her pension after retiring (life expectancy). In principle, the errors in these assumptions can go either way. The assumed interest rate has been very stable over long periods of time but the actual interest return has cyclical variations from year to year. The bigger problem is with life expectancy, which has been growing more rapidly than was assumed only a few years ago. As a result, many defined benefit pensions are under funded.

When the funds saved turn out to be insufficient to finance the pension promised, who should pay the difference? The traditional defined benefit (guaranteed pension amount) approach places the burden of covering shortfalls on the employer that promised the benefit. Surely big, wealthy American corporations can absorb this risk better than poor vulnerable workers. Maybe.

What happens when the company offering the defined benefit pension goes broke as happened to Enron and United (some of United’s pension liabilities were written off or reduced under Chapter 11 reorganization so that it could continue to operate as a profitable firm)? The pension promise is broken and the shortfall is absorbed by the workers/pensioners (and to some extent by the US Pension Benefit Guarantee Corporation).

The movement now underway by employers to replace defined benefit pensions with defined contributions from employers and employees shifts the above risks from the employer to the employee. The number of defined benefit pension plans in the United States has dropped from 112,000 in 1985 to 29,000 in 2005, though the remaining plans tend to be offered by larger firms. With a defined contribution plan, both the employer and employee commit to setting aside given monthly amounts toward a pension. If the actuarial assumptions that determined the expected pension amount prove to be incorrect, the risk falls on the employee in the form of a higher or lower pension.

Individually based pension plans can be of the defined contribution or defined benefit types. Those who prefer to shift the market risks to an insurance company may enter into a whole life or annuity contract with a guaranteed pension at the end. Nothing is free and shifting the risk to an insurance company must be paid for. Most whole life plans (no longer very popular) are a mix of defined contribution and minimum guaranteed benefit. They provide for some risk sharing between the policy holder and the insurance company. Those who badly misjudge their investments, fail to plan properly, or suffer bad luck can be saved by the social safety net. The net should be low enough not to encourage sloth or unreasonable risk taking but high enough to keep anyone from hitting the ground.

A different set of issues arise from tying the provision of health insurance to employers. It creates difficulties, hardships and anomalies when workers lose their jobs or wish to leave and/or change them. Why shouldn’t our health insurance follow us wherever we go? Maryland’s new “Wal-Mart” law, forcing large companies to spend a minimum amount on their worker’s health insurance seems a step backward. However, a government mandated minimum provision for health and retirement insurance, is not necessarily inconsistent with shifting the primary responsibility back to individuals and families. Whether the funds necessary are sent aside by employers or employees, they must be paid for out of potential wages in any event. Looking back it will be hard to understand why today’s system of employer provided health care insurance ever came about.

The deeper issue here is what role the state and individuals should play in providing for individual welfare. Starting with the Great Depression through WWII and the Great Society, America has increasingly centralized responsibility for individual welfare. To avoid WWII wage and price controls companies began to offer health and pension benefits, aspects of individual welfare that had previously been the left to individuals to provide. Company provided benefits became the norm. The state also took on greater responsibility to provide these benefits (Social Security, Medicare, and Medicaid). Centralization of worker benefits never reached the degree found in the Soviet Union where employers (government owned enterprises) were the sources not only of pension and medical benefits but of education, vacation, and recreational facilities, and of employment and income guarantees as well.

Centralized and state approaches are sometimes necessary but have a host of problems that are better understood today than they were fifty years ago. America has traditionally distinguished itself as a country of opportunity and self reliance. Most but not all of its citizens have flourished in this environment. It is also a country compassionate of its disadvantaged. A reconciliation of these deeply held attitudes was outlined by Ted Halstead and Michael Lind in The Radical Center: The Future of American Politics (Doubleday, 2001).

The trend away from state or company provided benefits as the norm, is a move back toward America’s traditional belief in individual and family responsibility. The state should encourage and facilitate this trend, which should include providing a more efficient and better focused safety net for those who fail in making adequate provisions for themselves.

Warren Coats is retired from the International Monetary Fund He is currently the U.S. Senior Monetary Policy Advisor to the Central Bank of Iraq and a Director of the Cayman Islands Monetary Authority.

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